The real reason for euro strength

The stubborn strength in EUR/USD has been attributed to relatively tight monetary policy stemming from the lack of asset purchases by the European Central Bank, currency reserve managers’ systematic euro buying on the dips in the absence of ECB easing indications, and cheaper Eurozone equity valuations relative to U.S. equities.

Three-month Libor EUR-USD spread

One overlooked interest rate spread is the three-month euro vs. three-month U.S. dollar Libor, which reached 0.066% in mid-April, the highest level since July 2012. During the height of the Eurozone debt and falling euro, the EUR-USD Libor spreads fell sharply as the cost of USD funding (USD-Libor) was boosted by Eurozone banks’ rush into raising USD funds to alleviate the unfolding liquidity crunch. Rising USD-Libor at crisis times was generally accompanied by rising Eurozone bond yields, falling euro and relative declines in EUR-Libor. Now it’s the opposite. Improved macro and market conditions in the Eurozone manifested by rising business surveys and falling bond yields are seeing three-month EUR-Libor at 0.32%, the highest since July 2012, while three-month USD-Libor stands below 0.25%.

“Rebounding euro,” highlights the improving spread in three-month Libor in favor of EUR, reflecting the improved situation in Eurozone capital markets, which reduces demand for USD-funding.

Another spread worth examining is the difference between Eurozone two-year government bond yields (using German two-year bunds) and their U.S. counterpart adjusted for inflation (using EU CPI and core PCE in the United States). Considering Germany’s real bond yields at -0.33% and those in the United States at -0.69%, the spread is +0.37% in favor of the euro. This means that despite U.S. yields being above their German counterpart, they’re not sufficiently priced to account for the higher inflation differential with the Eurozone, considering Eurozone CPI at 0.5% year-over-year and U.S. core PCE at 1.1%.

Another development is that of the continuous decline in EUR/USD one-month call option volatility, something which we have previously addressed in this column. EUR/USD volatility has proven to be generally inversely related to the spot EUR/USD. Falling EUR volatility is part and parcel of the decline in global equity volatilities resulting from U.S. and UK accommodative policies. Any indications that prolonged declines in volatility become associated with expectations of ECB quantitative easing could imply that such easing in Frankfurt would actually boost the euro as was the case in LTRO-1 (Eurozone QE) and LTRO-2, instead of causing its decline.

What could prompt euro Libor lower? There is increased chatter that the ECB could slash rates or even head off a program of asset purchases to tackle ultra-low inflation. The ECB would most likely opt for gradual verbal intervention to win some time before any improvement is seen on the inflation front. Recent remarks from ECB president Draghi and Governing Council member Noyer that further currency strengthening requires further monetary stimulus prove that the central bank remains in command. Contrary to what is perceived that the ECB’s verbal hints are losing their luster, one must distinguish between statements citing the possibility to act on various policy, and statements focusing on excessive currency appreciation with respect to the ECB’s goal of price stability. The latter has just begun and will likely be echoed throughout the rest of Q2.

If Eurozone CPI shows further deterioration in the upcoming months (falls below 0.5%) then the most likely course of action would be to reduce the main refinancing rate from 0.25% to 0.10% and slash the deposit rate to below zero. Any lack of progress from the price metrics would lead to a targeted-LTRO, similar to the Bank of England’s Funding for Lending Scheme, rather than large scale of private asset purchases.

Regarding timing, no ECB action is seen before the June meeting, when fresh ECB forecasts are available.

The EUR-USD Libor spread may be well below that of the levels prevailing in 2010 and 2011, but what’s crucial is the trend of the spread rather than the absolute figure. Today, the spread is favoring the euro in both trend (rising since August 2012) and absolute value (above zero). This will help support EUR/USD at 1.34 and any declines towards this level will prompt fresh buying as long as the status quo of low bond yields and immobile Fed is maintained.